The CBOE Volatility Index (VIX) is a real-time market index representing the market’s expectation of near-term volatility in the S&P 500 Index (SPX). Often referred to simply as “the VIX,” it’s derived from SPX index options prices and provides a 30-day forward projection of volatility, which is how fast prices change. Volatility is a key indicator of market sentiment, particularly the level of fear among investors. Maintained by CBOE Global Markets, the VIX is a crucial tool for quantifying market risk and understanding investor sentiment in the trading and investment world.
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How the VIX Works: Measuring Market Swings
The VIX functions by measuring the expected magnitude of price fluctuations in the S&P 500. Greater price swings within the index indicate higher volatility, while smaller swings suggest lower volatility. The VIX uses options prices to infer future volatility. Options contracts give the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price (the strike price) on or before a specific date. The prices of these options reflect the market’s expectation of how likely the S&P 500 is to move significantly.
Traders can trade VIX futures, options, and ETFs to hedge or speculate on volatility changes. Volatility can be measured using historical data or inferred from options prices (implied volatility). The VIX uses the latter method.
- Historical Volatility: Calculated using statistical analysis of past prices, including mean, variance, and standard deviation.
- Implied Volatility: Derived from options prices, reflecting the market’s expectation of future volatility. Option pricing models like the Black-Scholes model use volatility as a key input.
VIX and Market Volatility
The CBOE introduced the VIX as the first benchmark index to gauge market expectations for future volatility. This forward-looking index uses implied volatilities from S&P 500 index options to project the market’s expectations for the S&P 500’s volatility over the next 30 days. The S&P 500 is often considered a leading indicator of the overall U.S. stock market.
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Introduced in 1993, the VIX has become a globally recognized benchmark for U.S. equity market volatility. It is calculated in real time based on live S&P 500 prices. Calculations occur from 3:00 a.m. to 9:15 a.m. and 9:30 a.m. to 4:15 p.m. EST. CBOE began disseminating the VIX outside of U.S. trading hours in April 2016.
VIX Calculation
The VIX is calculated using CBOE-traded standard SPX options, expiring on the third Friday of each month, and weekly SPX options, expiring on all other Fridays. Only SPX options with expiry periods between 23 and 37 days are considered.
The calculation involves aggregating the weighted prices of multiple SPX puts and calls across a wide range of strike prices to estimate the expected volatility of the S&P 500 Index. These options must have valid bid and ask prices, indicating the market’s perception of which strike prices the underlying stocks will reach before expiry. Further details on the calculations can be found in the VIX white paper.
Historical Evolution of VIX
Initially, in 1993, the VIX was calculated as a weighted measure of the implied volatility of eight S&P 100 at-the-money put and call options. This was when the derivatives market was less active.
In 2003, CBOE partnered with Goldman Sachs to update the methodology, using a broader set of options based on the S&P 500 Index for a more accurate view of future market volatility expectations. This methodology remains in use for calculating other volatility index variants.
Trading the VIX and its Derivatives
The VIX has enabled volatility to be traded as an asset through derivative products. The CBOE launched VIX-based futures contracts in March 2004 and VIX options in February 2006, creating a new asset class.
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VIX-linked instruments offer pure volatility exposure, used by active traders, institutional investors, and hedge fund managers for portfolio diversification. Historical data shows a strong negative correlation between volatility and stock market returns: when stock returns decrease, volatility increases, and vice versa.
While the VIX itself cannot be directly bought, investors can gain exposure through futures or options contracts, or VIX-based exchange-traded products (ETPs) like the ProShares VIX Short-Term Futures ETF (VIXY) and the iPath Series B S&P 500 VIX Short-Term Futures ETN (VXX).
Active traders also use VIX values to price derivatives based on high-beta stocks, with beta representing how much a stock price moves relative to the broader market.
VIX Variants and What They Tell Us
Following the VIX’s popularity, the CBOE offers several variants for measuring broad market volatility, including:
- CBOE Short-Term Volatility Index (VIX9D): Reflects the nine-day expected volatility of the S&P 500 Index.
- CBOE S&P 500 3-Month Volatility Index (VIX3M)
- CBOE S&P 500 6-Month Volatility Index (VIX6M)
- Nasdaq-100 Volatility Index (VXN)
- CBOE DJIA Volatility Index (VXD)
- CBOE Russell 2000 Volatility Index (RVX)
The VIX signals the level of fear or stress in the stock market, using the S&P 500 as a proxy for the broad market, earning it the nickname “Fear Index.” Higher VIX values indicate greater fear and uncertainty, with levels above 30 suggesting significant uncertainty. Irrational investor behavior can be triggered by real-time news coverage.
Interpreting VIX Values
- VIX > 30: Generally linked to high volatility due to increased uncertainty, risk, and fear among investors.
- VIX < 20: Typically corresponds to stable, stress-free periods in the markets.
- Long-Run Average: The historical average of the VIX is around 21.
Hedging Downside Risk with the VIX
Buying put options, whose price depends on market volatility, can hedge downside risk. It is advisable to buy options when the VIX is low and put premiums are cheap. Protective puts become more expensive when the market declines.
The Bottom Line
The CBOE Volatility Index (VIX) provides valuable insight into market sentiment by quantifying market expectations of volatility. It assists investors and traders in assessing potential risks and making informed trading decisions. While the VIX is not directly tradable, investors can gain exposure through related funds and notes.
